Five Things for Tuesday, May 19

Economics 101; Will the Real Economic Crackpots Please Stand Up?; BlackRock Draws Scrutiny as U.S. Adviser and much more.

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1) Economics 101

Whenever I mention to friends that I see a structural shift in consumer behavior and attitudes, it's almost universally dismissed as some kind of crackpot theory. Which is true, but only because the pendulum has swung so far the other way toward the broad acceptance of monetary lunacy that anything else, by definition, must be the views of a nut job.

In the early 1990s, dozens of big time colleges and universities created degree programs centered entirely around the premise that financial engineering could escape the most basic rule of economic law; that consumption cannot exceed income indefinitely because there is a limit to how much debt can be serviced in the economy. If we can strap a monkey to a rocket and blast it into space, then surely we can strap Mr. and Mrs. Jones to a Visa card and blast them into a shopping mall. At least, that's how the reasoning looks in hindsight. At the time, however, while we were busy concocting models to support these financial illusions, Mr. and Mrs. Jones were the least important variable in the equations. And then reality caught up.

The San Francisco Federal Reserve last week released a fairly modest paper, both in scope and conclusions, on U.S. household leverage, and its inevitable unwind. As measured by the ratio of debt to personal disposable income, household leverage increased only modestly from 1960 to the mid-1980s, from 55% to 65%. However, over the next two decades, leverage more than doubled, reaching an all-time high of 133% in 2007.

Meanwhile, over that same period, the massive rise in household debt was accompanied by a steady erosion in the personal saving rate. On the one hand, the combination of increased leverage and lower savings was a powerful force driving a significant amount of U.S. economy growth. But, leverage can work in two ways; sharply increasing returns on the way up, creating losses at a terrifying pace on the way down. And even as we've spent the past 15 years enjoying the former while trying desperately to work around the latter, the reality remains: consumption cannot exceed income indefinitely because there is a limit to how much debt can be serviced in the economy.

Business deleveraging, consumer deleveraging; this is how the process of deflation runs its course. And deflation is really just a matter of a structural shift in the psychology of consumers and businesses; a shift in time preferences and risk appetites. Monetary and fiscal policymakers can make credit available, but they cannot make lenders lend, or potential borrowers take on more debt... even when it is rational to take on more debt.

So we've had our fun, now the payback time is upon us. When will it end? It's simply Economics 101, lesson two: Real lending and economic activity will only improve when real savers see real value at the right level of risk. That will only occur in the short-run with vastly lower prices, or in the long-run with stagnant prices and the benefit of time.

2) Will the Real Economic Crackpots Please Stand Up?

I saw the following headline on Bloomberg this morning, a vicious reminder of just which deranged cult is running the asylum:

"I'm advocating 6 percent inflation for at least a couple of years," says Rogoff, 56, who's now a professor at Harvard University. "It would ameliorate the debt bomb and help us work through the deleveraging process."

"Mankiw says the central bank should pledge to produce "significant" inflation. If Americans were convinced of the Fed's commitment, they'd buy and borrow more now, he says."

Gregory Mankiw is a former White House adviser, and Kenneth Rogoff was chief economist at the International Monetary Fund. Their credentials far exceed mine. I'm a simple man, a mere traveler who hails from the dark and bloody ground of Kentucky. Which means I have one advantage over Mankiw and Rogoff, an almost innate ability to recognize a scam for what it is thanks to the genetic assemblage of more than a century's worth of gamblers, horse traders, whiskey manufacturers, coal miners and hill people.

So whenever I hear someone make a case for higher inflation as a means of "helping the economy", what I see is someone standing on a whiskey barrel in the town square, peddling snake oil - fer all that ails ye.

-What's in it?

-Why it's an elixir, young man.

-A lick sure?

-A restorative, a healin' potion.

- But what's it made out of?

- Oh, many, many ingredients, too numerous to mention.

- If I know what's in it, maybe I can make my own?

- Ho ho, a commonly naive assumption, my young friend. This product can only be manufactured by experts, men formally trained in the metallurgical arts, like doctors, but with science on their side.

Like you, I've been there; seen that. The problem is they keep changing the branding, the label on the snake oil. These days its called "inflation." But here is all ye need know, my fellow travelers:

"There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved." - Ludwig von Mises

So ask yourself two things, 1) who gains by selling us this snake oil? and 2) who loses if we refuse to buy it?

3) BlackRock Draws Scrutiny as U.S. Adviser

Saw this article from the New York Times on BlackRock (BLK)making the rounds today:

Ok, here's the deal. BlackRock's role as an adviser to the U.S. government and its profits as a manager of troubled assets might be... now, sit down... it might... wait, just hold on, I know this is crazy-sounding... but there's a chance.... by that I mean it's theoretically possible... not a sure thing, mind you, but in theory, there is some small probability that the company that is simultaneously being paid by by the government to price and sell troubled assets while buying those same troubled assets for private clients faces an inherent conflict of interest.

I know, it's crazy talk. How could this possibly happen? Well according to the Times, "Without naming BlackRock, federal auditors have warned that any private parties that purchase distressed assets on the government's behalf could use generous federal subsidies to overpay, artificially pushing up the price of similar assets that they manage for their own portfolios."

Poppycock!, you say. And at least one person, James R. Wilkinson, who served until January as the chief of staff to the former Treasury secretary, Henry M. Paulson Jr., would agree with you. According to the Times, Wilkinson described BlackRock's co-founder and chief executive, Laurence D. Fink, as a "patriot."

4) More Unconscious Herding Impulses

Fascinating article in the Science section of the Timestoday on why we buy the things we buy. According to the piece, Dr. Geoffrey Miller, an evolutionary psychologist at the University of New Mexico, says that much of the pleasure we derive from the things we buy comes from unconscious instincts that they will either enhance or signal our fitness by demonstrating intelligence or some of the Big Five personality traits: openness, conscientiousness, agreeableness, stability and extraversion.

"In a series of experiments, Dr. Miller and other researchers found that people were more likely to expend money and effort on products and activities if they were first primed with photographs of the opposite sex or stories about dating."

What I most liked about the piece, however, was the unconscious shift (a meta-shift ?) that the writer made halfway through the piece: "The grand edifice of brand-name consumerism rests on the narcissistic fantasy that everyone else cares about what we buy. (It's no accident that narcissistic teenagers are the most brand-obsessed consumers.) But who else even notices? Can you remember what your partner or your best friend was wearing the day before yesterday? Or what kind of watch your boss has?"

See, the "grand edifice of brand-name consumerism" which rests, it is now apparently manifest, on the "narcissistic fantasy that everyone else cares about what we buy," goes hand-in-hand with the deeper herding impulses that make the conditions for deflation possible; shorter time preferences, risk aversion. "We evolved as social primates who hardly ever encountered strangers in prehistory," Dr. Miller says. "So we instinctively treat all strangers as if they're potential mates or friends or enemies. But your happiness and survival today don't depend on your relationships with strangers. It doesn't matter whether you get a nanosecond of deference from a shopkeeper or a stranger in an airport."

5) News & Weirdness

Morgan Stanley (MS), JPMorgan (JPM), Goldman (GS) Said to Plan TARP Repayment - BloombergA wise man once said, Neither a borrower nor a lender be; and these cats were all losing money on both... at the same time.

"Hallucination Fish" Caught Off UK Coast - Practical FishkeepingA species of marine fish that has been reported to cause LSD-like hallucinations has been caught off the coast of southern England. "In 2006 two men who ate the fish at Mediterranean restaurants suffered "terrifying" visual and auditory hallucinations, which toxicologists linked to their consumption of the species."

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